3.3 Revenues, Costs and Profits

Question 1

What is revenue ?

Answer 1

• the income generated from the sale of goods and services in a market

Question 2

What are the three main ways to look at revenue ?

Answer 2

• total revenue: TR = Q x price
• average revenue: AR = TR /output (Q) ➡️ also known as the demand curve
• marginal revenue: MR = change in TR / change in Q

Question 3

What is marginal revenue ?

Answer 3

• the change in revenue from selling one extra unit of output

Question 4

When does maximising revenue occur ?

Answer 4

• maximising total revenue occurs where MR is 0 ➡️ no more added revenue can be achieved from producing and selling an extra unit of output
• when MR = zero (PED = 1)

Question 5

PED and max revenue ?

Answer 5

• when demand is elastic (>1): price increase = fall in revenue / price decrease = increase in revenue
• when demand is inelastic (<1): price increase = increase in revenue / price decrease = decrease in revenue

Question 6

MR and PED ?

Answer 6

• when MR is posItive, PED is relatively elastic (a fall in price is proportionately smaller than the increase in quantity demanded)
• when MR is negative, PED is relatively inelastic (a fall in price is proportionately larger than the increase in quantity demanded)

Question 7

PED and total revenue ?

Answer 7

• PED along a straight line demand curve will vary
• at high prices, a fall in price will have an elastic response ➡️ cutting prices = rise in total revenue
• demand is price inelastic (PED < 1) towards the bottom of the demand curve ➡️ fall in price = drop in total revenue

Question 8

What is meant by price makers ?

Answer 8

• have the ability/power to set their own prices for the goods/services they sell
• occurs in all imperfectly competitive markets
• demand cure (AR curve) is downward sloping
• MR will lie below AR

Question 9

What is meant by price takers ?

Answer 9

• operate in highly/ perfectly competitive markets + have a low % of market share
• have no pricing powers ie. no control over price + must accept what price is set by the market
• they have a perfectly elastic demand curve + AR will be identical to MR (bcs every unit will be sold at exactly the same price)
• their TR curve will be an upwards sloping line

Question 10

What are economic costs ?

Answer 10

• economic costs are incurred by a business engaged in producing/supplying an output
• combination of explicit costs and opporutnity cost
• eg. if an entrepreneur invests £200,000 of their own money into a business, that money could have yielded an alternative return (interest) by being saved in a bank ➡️ the next best alternative rate of return on this money is treated as part of the economic cost of production

Question 11

What are fixed costs ?

Answer 11

• do not vary at all as the level of output changes in the short run
• have to be paid whatever the level of sales are achieved (incurred even if output is 0 in the short run)
• the higher level of fixed costs in a business, the higher the output must be in order to breakeven
• eg. rent, bills, consulting fees, fixed salary costs

Question 12

What are variable costs ?

Answer 12

• costs that relate directly to the production or sale of a product
• an increase in short run output (Q) will cause total variable costs to rise (TVC)
• AVC = TVC / output
• variable cost is determined by the marginal costs of extra units as more labour is hired
• eg. commission bonuses, wage costs, raw materials, energy/fuel, packaging costs

Question 13

Calculating total cost ?

Answer 13

• TC = total fixed costs + total variable costs

Question 14

Calculating marginal cost ?

Answer 14

• MC = the addition to total costs of producing one more unit
• MC= change in TC / change in qnty

Question 15

Calculating average costs ?

Answer 15

• AC = total cost / output

Question 16

Cost of production in the short/long run ?

Answer 16

1. short run: at least one of the factor inputs is fixed (usually capital or land) ➡️ in the short run, businesses are constrained with fixed & variable factors
2. long run: all factors of production are variable + the scale of production can also change ➡️ firm can benefit from economies of scale

Question 17

What is the concept of diminishing marginal returns ?

Answer 17

• in the short run, at least one factor of production is fixed (often capital or land) thus the only way to increase output is by employing more workers
• initially, adding additional workers will increase productivity (as workers use division of labour + focus on tasks that they are relatively better at)
• however as more workers are added to the fixed amount of capital/land it will become increasingly scarce ➡️ not enough to go round causing workers to get in each others way as too many workers in a fixed area
• thus productivity will fall once passed the optimum point, at the point where marginal product start to fall - ‘diminishing returns has set in’

Question 18

How is the concept of diminishing marginal productivity/returns used to explain the shape of short run costs curves ?

Answer 18

• total product = total output
• marginal product = the additional output produced when an extra worker (or other factor of production) is employed
• average product = total output / no. of workers ie. productivity

Question 19

Concept of diminishing marginal returns (precise) ?

Answer 19

• when diminishing returns set in then the marginal product of labour starts to fall
• when marginal product of labour declines below existing average product then the average product of labour will fall ➡️ marginal cost of supplying extra output will increase

Question 20

Cause of shifts in short run costs ?

Answer 20

1. changes in the unit cost of production: lower unit costs = can supply more at each price
2. fall in the exchange rate: causes higher prices of imported components + raw materials
3. advances in production technologies: outward shift of supply
4. the entry of new producers into the market: outward shift
5. favourable weather conditions eg. agricultural products - increased supply
6. taxes, subsidies + govt regulations: indirect taxes (inward shift of supply), subsidies (outward shift), regulations increase costs (inward shift)

Question 21

What does a rise in fixed costs do ?

Answer 21

• causes an upward shift in ATC but does not cause the marginal dost curve to change
• a change in fixed costs will only shift the AC curve and no the MC curve whereas a change in variable costs will shift both

Question 22

Ways in which changes in govt economic policy influence the costs of business ?

Answer 22

• changes in value added tax (VAT) + other indirect taxes on producers
• environmental taxes eg. carbon tax + introducing a min price for each tonne of carbon emitted within the EU carbon trading scheme
• changes in labour market interventions eg. national min wage
• govt subsidies targeting producers eg. employment subsidy or guaranteed min payment

Question 23

How a rise in the min wage may affect the profitability of a business ?

Answer 23

• employer cannot pay below it therefore firm experiences a rise in their VC (as hourly wage costs increase)
• assuming that labour productivity remains the same, AVC will rise + MTC + ATC
• thus profit margin will fall ➡️ effect on profit depends on whether the firm passes on higher costs to consumers (depends on PED)

Question 24

What are returns to scale ?

Answer 24

• how the output of a business responds to a change in inputs (long run) ➡️ the rate at which output increases when the factors of production are increased
• affects LRAC of a business

Question 25

What are economies of scale ?

Answer 25

• advantages that arise for a firm because of its larger size or scale of operation ➡️ leads to a fall in average costs thus increased profits (or lower price for the customers if passed on)
• exists when LRAC fall as output rises ➡️ improved efficiency + can give a business a competitive advantage in a market

Question 26

Average costs formula ?

Answer 26

• total costs / quantity

Question 27

What are the internal economies of scale ?

Answer 27

1. purchasing: monopsony power eg. bulk buying of raw materials ➡️ reduce AC due to unit discounts
2. technical: eg. investing in new specialist tech to increase efficiency ➡️ more advanced = greater output + experience = less mistakes
3. managerial: employing specialist staff to supervise eg. manager to run business functions ➡️ better planning + decision making (specialised = less mistakes)
4. marketing: access to large scale promotion, can buy marketing in bulk and/or increases sales ➡️ lower AC
5. financial: wider range of finance options available eg. lower interest rates on loans for larger firms as more ‘credit worthy’ or can raise new capital on stock market (sale of equities)
6. risk bearing: a more diverse product range = larger firms more resilient ➡️ risk spread over a large output
7. social and welfare: can give more benefits to staff thus can attract & retain better employees ➡️ more efficient
8. network: networks of suppliers/customers with a low marginal cost of adding new user ➡️ the more users the lower the fixed costs per unit thus lower AC

Question 28

What are internal economies of scale ?

Answer 28

• when AC fall when the firm grows

Question 29

What are external economies of scale ?

Answer 29

• are factors that leads to a fall in AC as an industry grows (outside of the business) eg. better transport networks
• lower unit costs for most/all firms inside the market ➡️ entire LRAC curve will shift downwards

Question 30

External economies of scale ?

Answer 30

• lost of firms doing similar things - can share resources
• high no. of staff with desired skills ➡️ reduces training requirements
• ability to pool/share R&D
• suppliers + service providers to that industry may chose to locate close by ➡️ cheaper transport costs
• local colleges/uni’s may start to offer qualifications that are desirable to the firm
• may even see improved infrastructure & public transport

Question 31

What are diseconomies of scale ?

Answer 31

• inefficiencies that can creep in when a firm operates on a large scale ➡️ the factors lead to a rise in AC due to decreasing returns to scale
• means that the business has moved beyond their optimum size + productively inefficient

Question 32

Examples of diseconomies of scale ?

Answer 32

• lack of motivation: in larger firms workers may feel unappreciated or not valued as individuals + can be more difficult for managers in larger firms to develop the right relationship with workers ➡️ if motivation falls, productivity may fall leading to inefficiencies
• poor communication: can be easier for smaller firms to communicate with all staff in a personal way - in larger firms there is likely to be a greater use of written notes rather than in person ➡️ messages may not get read or misunderstood
• coordination: very large businesses take a lot of organisation ➡️ increased meetings + planning to ensure that all staff know what they are meant to be doing ➡️ new layers of management may be required = increased costs + created further links in the chain of communication

Question 33

Technical economies of scale ?

Answer 33

• expensive (indivisible) capital inputs: large-scale businesses can afford to invest in specialist capital machinery
• specialisation of the workforce: larger firms can split the production processes into separate tasks to boost productivity eg. use of division of labour in the mass production of motor vehicles and in manufacturing electronic products
• law of increased dimensions (the container principle) - linked to the cubic law where doubling the height + width of a tanker or building leads to a more than proportionate increase in cubic capacity ➡️ the application of this law opens up the possibility of scale economies in distribution and freight industries, also in travel and leisure sectors with the emergence of super-cruisers ➡️ important in energy sectors, office rental and warehousing
• learning by doing: the average costs of production decline in real terms as a result of production experience as businesses cut waste + find the most productive means of producing output on a bigger scale

Question 34

Consequences of diseconomies of scale ?

Answer 34

• lead to a rise in a firm’s LRAC of production.
• result from a business expanding beyond an optimum size and losing productive efficiency
• higher LRACs will reduce the profitability of a business if their prices remain the same

Question 35

Examples of external diseconomies of scale ?

Answer 35

• as an industry grows demand for its supplies will increase ➡️ will pull prices upwards
• localisation of businesses leads to increased demand for transports and thus ⬆️ transport costs
• competition among firms for the factors of production + raw materials ➡️ raises the price of raw materials + other factors of production

Question 36

What is the minimum efficient scale ?

Answer 36

• the scale of output where internal
  economies of scale have been fully exploited
• corresponds to the lowest level of output at which the lowest point on a firms LRAC curve is reached
• likely to be low relative to the size of market demand in a very competitive industry - meaning there is room for many businesses to compete eg. hotels competing for custom in a city centre
• MES is likely to be high in a natural monopoly ➡️ means that the industry will be highly concentrated
• if LRAC remains the same as output increases, then a firm is experiencing constant returns to scale

Question 37

Three causes of a business having a high minimum efficient scale ?

Answer 37

1. the fixed costs of setting up production are large e.g. in pharmaceuticals where it can cost of hundreds of millions of £s to bring a new drug to market because of research and testing costs.
2. the marginal cost of supplying to extra customers is low relative to fixed costs eg. many digital businesses grow rapidly because the marginal cost of adding one extra user to the network is very low ➡️ can benefit from network economies of scale
3. with a natural monopoly, LRAC may continue to fall across the entire range of output which means that the minimum efficient scale is a very high percentage of total market demand ➡️ thus, there might be room for only one firm to fully exploit economies of scale

Question 38

Examples of markets with high/low minimum efficient scale ?

Answer 38

high:
- Water, gas and electricity supply
- Underground transport systems
- Social networks and search engines

low:
- Cafes and coffee shops in a large city
- Hotels
- Dry cleaners

Question 39

What is normal profit ?

Answer 39

• TR = TC ➡️ min profit needed to keep factor inputs in their current use in the LR
• when a business makes sufficient revenues to cover the overall costs of production (breakeven)
• reflect the opportunity costs of using funds to finance a business eg. if you put £200,000 of savings into a new business, those funds could have earned a low-risk rate of return (interest) by being saved in a bank account
• included in the ATC curve

Question 40

What are supernormal prodits

Answer 40

• TR > TC or AR > AC
  ie. profit achieved in excess of normal profit
• when firms making supernormal profits, there is an incentive for other producers to enter a market

Question 41

Subnormal profits ?

Answer 41

• profit less than normal (i.e. price per unit < AC ) ➡️ ie.economic loss
• If we looked at a business’s accounts, it may appear that they are making an “accounting profit” (remember accountants do not include opportunity cost in the business’s costs of production)

Question 42

Importance of profit ?

Answer 42

• finance for capital investment & research: retained profits are a key source of finance for businesses undertaking investment + funds for acquisitions
• market entry: rising supernormal profits send signals to other producers within a market
• demand for and flow of factor resources: resources flow where the risk-adjusted rate of profit is highest
• signals about health of the economy: rising profits might reflect improvements in supply-side performance + are also the result of higher levels of AD eg. during an economic recovery

Question 43

Strategies to increase profit ?

Answer 43

• reduce overhead costs (fixed costs) so that average cost per unit falls
• increase labour productivity / outsource some production to lower cost suppliers
• move up the value chain ➡️ develop new products with a PED and higher income elasticity of demand
• discount prices if the business estimates that demand is highly price elastic
• find new customers in new markets e.g. from exporting to more countries

Question 44

Short run shut down points ?

Answer 44

• in the short run a firm will supply their products as long as price per unit is greater than or equal to average
  variable cost (i.e. where AR = AVC).
• providing that P>AVC, then firms will stay in the market in the short run because there is a contribution being made to covering the fixed costs of production ➡️ If price (AR) is less than AVC, then the firm will likely shut down
• this is called the short-run shut-down price in a competitive market

Question 45

Long run shut down points ?

Answer 45

• a business needs to make at least normal profit in the long run to justify remaining in an industry (i.e. at a price and output where P=AC) ➡️ if price (or AR) is less than AC in the long run, then the firm will shut down in theory
• firms can survive while making a loss because the managers are satisficing, or where a downturn is seen as temporary and demand is expected to pick up again
• losses might be cross-subsidised by profits in another sector/market